The balancing act

Credit derivatives product companies have been around for more than five years, but after several false starts, new entrants are finally beginning to emerge, bringing a mix of approaches and structures to the market. Radi Khasawneh reports

The buzz around credit derivatives product companies (CDPCs) has intensified this year, with three companies being launched in the first quarter - the first new entrants since New York-based Primus Financial Products and Athilon Capital set up shop in 2002 and 2004 respectively. The companies, which take 12 to 18 months to establish, are notoriously difficult to get off the ground. Nonetheless, several more are expected to get the green light from the rating agencies this year, bringing with them a variety of structures and strategies. In particular, some CDPCs are looking to branch out from the world of corporate credit into new asset classes, such as asset-backed securities.

CDPCs were spawned by the earlier derivatives product companies that emerged in the interest rate world, pioneered by Connie Voldstad at Merrill Lynch in the early 1990s (Risk July 2007, pages 38-39). At its heart, the concept is simple: CDPCs are structured finance operating companies that make highly leveraged investments by selling protection on corporate single-name credit default swaps (CDSs) and collateralised debt obligation (CDO) tranches. The crucial component is an AAA rating, but CDPCs also need to convince the credit departments of bank counterparties to extend lines of credit. This can be problematic as, like the much bigger monoline insurance companies, CDPCs do not post collateral.

This time last year, CDPCs looked set to take the market by storm, with Moody's Investors Service estimating that 12 new companies were in the works. Things have moved slowly since then, but it seems the bottleneck has been resolved, with 25 CDPCs now on the way, according to a Moody's report published in February. Others are more conservative on that number, but the consensus is that at least six will have been launched by the end of this year, with considerable variation in asset classes, investment guidelines and possible structures.

The most notable aspect is that both rating agencies and investors seem willing to allow the companies, which until 12 months ago were restricted to selling single-name CDS protection and investing in super-senior tranches of corporate CDOs, to accrue positions in other asset classes - in particular, asset-backed securities (ABSs) - and to move lower down the capital structure.

Well before the rise in subprime mortgage delinquencies rattled the US market, CDPCs had been working with rating agencies to allow them to trade ABSs. While investor appetite may be dwindling for CDOs of ABSs, particularly those backed by 2006 vintage subprime mortgages, the spread levels being offered are a definite opportunity for investors in the senior part of the capital structure, so long as firms are choosy about what they invest in and carefully analyse reference portfolios, say some analysts.

Primus Financial Products has been investing in single-name CDSs on ABSs since it received consent to invest in these assets in November last year, and intends to advance into tranches of CDOs of ABSs later this year. Athilon, meanwhile, is also planning to dip its toes into the ABS market, and is setting up a separate entity exclusively for its ABS investments.

Some new entrants are also planning to include ABSs as part of their investment programme. Invicta Credit, established earlier this year by MassMutual, a Springfield, Massachusetts-based mutual life insurance company and its investment management arm Babson Capital, is in the process of getting approval from Standard & Poor's to invest in single-name ABSs and tranches of CDOs of ABSs. The company has already received approval from Fitch Ratings to invest in these products.

Invicta is also considering moving down the capital structure. It currently restricts itself to super-senior and senior corporate tranches (attaching at 11-20% and 9-11%, respectively). However, it may look beyond AAA tranches if spreads continue to widen - although the CDO of ABS attachment points would continue to be high.

"Invicta is quite far along the road of integrating ABS investments, both in single names and CDOs, into the CDPC structure," says Ian Hawkins, president and risk manager of Invicta Credit. "The one caveat we have is that given the market developments in the subprime space, we would reach out to our debt investors and explain our capabilities and our strategy before we start executing transactions, as a matter of good communications. Our basic plans there have not changed, but there is certainly more spread in the market than we had anticipated when drawing up our business plan."

Positive development

This might in fact be a positive development for the market as a whole. There is currently a lack of investors in the super-senior tranche of CDOs of ABSs, so CDPCs operating in this area would fill the void and help stabilise the market, say dealers. As such, greater diversity in CDPC strategy is generally welcomed.

"From a counterparty perspective, it would clearly make it easier to trade with CDPCs if diversification by asset class happens," says Tony Venutolo, global head of synthetic structuring at Societe Generale Corporate and Investment Banking (SG CIB) in London. "This is a relatively new area for credit departments, and they like to see big institutional backing and total transparency on the underlying portfolios. You need to know at any time what the exposure is."

However, while this increased flexibility may appeal to counterparties, it can have a negative effect on rating agency treatment in the initial stages. "There is a tension between making your business model narrow and broad," says Walter Gontarek, founder and chief executive of Channel Funding, one of the most recent CDPC new entrants, backed by Landesbank Baden-Wurttemberg (LBBW), French bank Calyon and Belgium's KBC Financial Products. Channel Funding does not plan to invest in ABSs. "One can minimise the uncertainty in the moving parts and the complexity, and therefore you may have a greater chance of receiving the all-important AAA rating. But when you go to counterparties, they typically want a reasonably broad CDPC that is going to be more relevant to them as a counterparty. Finding the right balance between the two opposing forces is key."

The model adopted by Channel Funding includes investments in static and managed CDO tranches on corporate, sovereign and supranational obligors, subject to rating agency approval.

As well as expanding into new asset classes, some CDPCs are considering different business models. At least one CDPC in the pipeline, the Bank of Montreal-backed Pallium Investments, is planning a radical departure from the existing model. Like monoline insurers, CDPCs have been strictly non-collateral posting vehicles to date. This produced a great economic advantage and, coupled with its AAA rating, is intrinsic to how CDPCs are viewed. However, the fact that these companies don't post collateral exacerbated what was already the major sticking point in the model - how to convince bank credit departments to open counterparty credit lines for CDPCs.

Several of the major banks will not supply credit lines to derivatives investment companies that do not post collateral. Many participants point to JP Morgan and Deutsche Bank as being reluctant to do business with CDPCs as counterparties, although both banks declined to comment. However, there are plenty of others that will trade with CDPCs - as of the last reporting date, Invicta Credit had gathered 11 counterparties and was looking to increase that figure.

A typical CDPC has around 60 times leverage, with a cap at 80 times. For single-name-only CDPCs, the leverage would be at around half that level. For example, Koch Financial Products, a single-name CDPC owned by Koch Industries (an energy company based in Scottsdale, Arizona) and launched in the first quarter of this year, has a cap of 50 times leverage. The returns, however, would be comparable to other, more leveraged CDPCs as the spread gained from single-name CDS investments is expected to be at least twice that of a super-senior tranche.

Companies that post collateral would be vulnerable to margin calls in the event of a drop in the market value of their holdings. That affects the amount of leverage they can use, and in a worst-case scenario would lead to an enforced sale of assets, which opens them up to increased liquidity risk.

"If there is a collateral posting vehicle, you have higher volatility on the asset side and that means even less leverage than a single-name CDPC, but you can go into the more risky and higher volatility asset classes generating a higher return like in a constant proportion debt obligation transaction," explains Thomas Keller, managing director in structured credit investments at LBBW, one of the backers of Channel Funding. "The main advantage of that approach is that they have less of a challenge in finding counterparties in the short run."

That advantage is described by one banker as a potentially huge development. Indeed, some say there has been a recent shift in counterparty appetite for CDPC-style credit lines - something that could change with the posting of collateral. "What is interesting is that the negotiating dynamics between dealers and CDPCs has changed," says Venutolo at SG CIB. "Dealers used to be keen, but have become a little more cautious and discriminate."

However, the benefits of posting collateral must be balanced against the consequent need for mark-to-market triggers to be inserted into the swaps. That would mean the company might have to liquidate positions as the triggers are hit, rather than gradually sell off its assets.

"We are a continuation vehicle, which means we have no market value trigger resulting in an unwind of the credit swap book," explains Gontarek of Channel Funding. "In this market, with the spreads moving around as they are, this is an attractive feature. With other terminating vehicles, people might look at them a little closer in the context of mark-to-market volatility."

While the collateral-posting CDPC might be open to greater mark-to-market and liquidity risk, these vehicles may find it easier to raise funding. For those vehicles, scale and asset diversification are key differentiating features.

"Both strategies will succeed and write business, and I don't have any doubts about either one failing outright," says Gontarek. "What will be interesting is to see which method business model generates the higher return on equity in, say, five years' time."

PUBLIC VERSUS PRIVATE

New York-based Primus Financial Products is the only credit derivatives product company (CDPC) that has gone public so far, conducting an initial public offering (IPO) in 2004. Taking such a company public was, at the time, seen as a groundbreaking move. The rationale was that this would provide a liquid exit strategy for CDPC investors, making it attractive for players such as private equity companies.

"As a public company, counterparties like the Securities and Exchange Commission regulation, and the high level of disclosure and control as part of the business model," says Tom Jasper, chief executive of Primus. "We have diversified our investor base and raised capital in the US public market. Some of the new entrants have been set up by financial sponsors with deep pockets, and there is no absolute reason why you have to be a public company, but we chose to do that to give us a level of freedom from our sponsors."

In fact, some market participants, both on the investor and bank counterparty side, have voiced suspicion of new entrants that expressly wish to conduct an IPO as part of their initial business plans, although none of the CDPCs that have been launched to date have gone down that road.

The root of the criticism is that the Primus IPO provided their financial sponsors with a partial exit from their investment. As the assessment of CDPCs, both as counterparties and investments, is inevitably bound up with the strength and commitment of their sponsors, this has caused plenty of trepidation.

"I think the worst thing for a counterparty is when the manager and the structuring team and the sponsor are just looking for an IPO," says a banker involved in CDPCs. "That puts pressure on growth and figures in the first year, which is good for equity and debt holders, but bad for the counterparties. From a management point of view, you cannot have a feeling that this is a real continuation business."

Athilon Capital had announced a plan to conduct an IPO in 2005, but has since cooled on the idea.

FUNDING DIVERGENCE

One of the most crucial aspects for any credit derivatives product company (CDPC) is funding. The two established players in this market - New York-based Primus Financial Products and Athilon Capital - took different approaches to raising debt.

Primus has used a mix of term debt and auction rate notes to raise funding. Auction rate notes are reset every 28 days, but offer a substantial discount to term debt. Primus estimates that the blended cost of funding for all auction rate notes rated AAA to A is in the low 20-basis-point area.

"When we started, the rating agencies only envisaged soft capital for CDPCs," says Tom Jasper, chief executive of Primus Financial. "Over time, we developed auction rate notes with Lehman Brothers and the rating agencies as a way of raising debt capital on a perpetual or long-term basis. It is a ratings-based market that relies on the underwriting bank to do their due diligence."

Since then, the other early CDPC, Athilon Capital, has moved to exclusively raising debt via auction rate notes. In fact, it raised $150 million of auction rate notes in March this year.

Newlands Financial, a CDPC backed by Deutsche Bank and managed by Paris-based asset management firm Axa Investment Managers, meanwhile, has exclusively used term debt in its structure. Term notes for CDPCs are intrinsically different from auction rate notes, as they require a long-term maturity - typically, they have a 30-year maturity with either five- or seven-year non-call dates, after which the coupons step up. These notes attract more traditional fixed-income investors.

Most other companies have tended to blend the funding structure with elements of both types of debt. Channel Funding, for example, issued $300 million of term debt in mid-July. In addition, it will issue $200 million of auction rate notes and equity over the coming months. Invicta, meanwhile, was initially capitalised with $400 million, a $150 million equity investment from MassMutual and a $250 million combination of AAA and AA rated term and auction rate debt.

"We do like the auction rate market. We see very attractive funding levels there and a very sophisticated investor base that can distinguish our paper from that of other institutions in general and other CDPCs, so we don't worry about contagion or spread widening as a result of the US subprime wobbles," says Ian Hawkins, president and risk manager of Invicta Credit. "We see it as prudent to have a significant element of term paper in the capital structure, and there is also some benefit to be had in terms of capital modelling."